Many insurance companies currently sell variable annuity contracts (VA's) that provide guaranteed death benefits and guaranteed withdrawal benefits. Variable annuities with such features provide a number of attractive benefits for the buyer:                The ability to invest in a variety of actively-managed equity and fixed income mutual funds (VA funds), with the objective of achieving superior investment performance;        Peace of mind for the buyer, since specified returns are guaranteed to be paid as withdrawal or death benefits, regardless of possible adverse fund performance; and        Investment flexibility, through reallocation of money between the different VA funds available, either automatically or when requested by the buyer.        
American life insurance companies have been offering guaranteed benefits on variable annuities for decades. Early designs offered de minimis guarantees (such as a guarantee that the annuity death benefit would not be less than the premium originally paid for the annuity). Intense competition, especially during the stock market boom of the late 1990's, led many life insurers to offer more elaborate and expensive guarantees. Such guarantees were usually either self-insured (i.e., notionally funded by some portion of contract fees) or reinsured, rather than hedged, as would be typical for other products with similar guarantees such as equity-indexed annuities (EIA's). See U.S. Pat. No. 6,049,772, Payne et. al., System for managing hedged investments for life insurance companies, as an example of how EIA's can be hedged.
The subsequent sharp decline in U.S. equity markets changed the focus of most life insurance companies: they became more concerned with managing the risk that they had taken on by guaranteeing VA returns, in some cases without full analysis of its magnitude. At the same time, U.S. insurance regulators and professional bodies such as the American Academy of Actuaries began work to ensure that the costs of variable annuity guarantees were reflected in the determination of reserve and risk-based capital requirements for such companies. It is generally believed that hedged benefits should be subject to lower capital requirements than unhedged benefits, since they subject the carrier to less risk.
Hedging the guaranteed benefits for a set of variable annuity contracts (VA hedging) is much more complex than hedging the benefits for a similarly-sized block of equity-indexed annuity contracts (EIA hedging), although both varieties of hedging can be classed as a type of option valuation problem. The additional complexity arises from a number of causes, including:                Active fund management: many VA funds are actively managed, so their returns will not in general match the returns on liquid hedging instruments such as equity index futures, as would be the case with an S&P 500-indexed EIA, for example;        The number of investment options: a single variable annuity contract may be invested in as many as 20 funds at a time, out of a total of 40, 50 or more VA funds;        Variety of guarantee structures: VA death benefits may depend on an accumulation of premiums at varying interest rates, the maximum account value achieved at any prior anniversary, a percentage of any investment gain in the contract, or some combination of these items. VA withdrawal benefits are similarly diverse;        Path-dependent benefits: the value of the guarantee under some of the guarantee structures depends not only on current VA fund values but on their history as well, making benefit valuation more difficult, and generally precluding the use of closed-form option valuation formulas;        Interest-rate dependence: the long time scale (10-20 years or longer) of VA benefit guarantees magnifies the importance of the time value of money, so that accurate hedging requires a more sophisticated yield curve model than would typically be used in valuing shorter-term options.        
Similarly, VA hedging is much more computation-intensive than EIA hedging. The complexities outlined above indicate that a number of apparently attractive computational shortcuts have pitfalls associated with them:                The value of a guarantee depends on fund returns that will not be perfectly correlated with a given set of hedging instruments. Modeling the funds including inter-fund correlations will lead to more accurate results than the simplistic assumption that each fund can be replaced by a linear combination of hedging instruments, especially if an asset allocation or rebalancing program is in effect. This is in sharp contrast to the situation for EIA's;        The difficulty of aggregating contracts with different mixes of VA funds while preserving optionality strongly suggests that a seriatim (contract at a time) valuation approach is the “gold standard” in terms of result accuracy, with any grouping of contracts requiring validation by comparing the results to this standard. Once again, this is in sharp contrast to the typical situation for EIA's;        The path-dependent nature of many guarantee structures, together with their dependence on interest rates, strongly suggests that Monte Carlo simulation will be necessary for option valuation, since closed-form formulas for the value of the guarantees may not exist;        These points (especially the first two) indicate that hedging guaranteed VA benefits is likely to be much more computation intensive than hedging EIA's.        
Variable annuity guarantee designs continue to evolve quickly as life insurance carriers gain a better understanding of VA hedging. As well, many life insurance companies are moving towards “unbundling” guaranteed benefits into independent riders to increase client flexibility while keeping costs reasonable. To be truly useful, any system providing support for VA hedging must be flexible enough to add new benefits easily, to handle new combinations of benefits easily, and allow the user to specify the minimum amount of customized code necessary. These are characteristics that might be associated with a program generator, rather than a static program.
Additionally, a VA hedging system is much more useful if it is easy to verify its calculations, not only because of the financial reliance placed on its results by the insurance company, but also to ensure that regulators can rely on its results in determining reserve and risk-based capital requirements.
It is clear from the foregoing considerations that there are competing objectives with respect to complexity, computational speed, flexibility, and correctness, and that in general these will be hard to reconcile. A shorter, simpler hedging program in a high-level interpreted computer language may be easy to modify and verify, but have run-times too long to be practical, while a more elaborate program in a compiled computer language may run faster but be hard to prove correct and hard to modify.
Accordingly, there is a need for a VA hedging system program generator with provision for both easy-to-verify high-level interpreted computer code and high-performance, machine-architecture-optimized compiled computer code, and a means for comparing results from these two execution paths.